How it works (Example):

Let's assume investor X buys 100 options of XYZ Company for $10 and then sells 100 options in XYZ Company for $12. The commission on both the purchase and the sale is $0.50, or $1 total. The net option premium is ($12 - $0.50) - ($10 - $0.50) = $1.00.

Why it Matters:

Net option premiums are a critical component in hedging strategies and other tactics designed to mitigate risk. When investors simultaneously purchase and sell options in a given security, they are generally intending to cap both the upside and downside of a position in a security, but they also may be engaging in a little arbitrage.

The idea is that the investor can make "free" money by skimming the net option premium on a position. In other words, because the investor has purchased and sold options on the security, the investor is essentially insulated from the effects of dramatic changes in the price of the underlying security (what he gains in the options sold, for example, he loses in the options purchased). The mitigated risk exposure means that, in theory, the investor can simply buy and sell options on the security and rake in the net option premium in the process.

CONTENT LIBRARY

InvestingAnswers is the only financial reference guide you’ll ever need. Our in-depth tools give millions of people across the globe highly detailed and thoroughly explained answers to their most important financial questions.

We provide the most comprehensive and highest quality financial dictionary on the planet, plus thousands of articles, handy calculators, and answers to common financial questions -- all 100% free of charge.

Each month, more than 1 million visitors in 223 countries across the globe turn to InvestingAnswers.com as a trusted source of valuable information.